SecondMarket weighs in on "verification" of accredited investor status

Quid pro quo for lifting the ban on "general solicitation or general advertising" in Rule 506 offerings, Congress requires companies should "verify" that persons purchasing are, in fact, accredited investors.

The thinking is that the current system of self-policing won't stand up to the onslaught of interest that may follow an offering hyped to the general public. That is, Congress assumes potential purchasers - whipped up into a frenzy on Twitter about a startup likely to be sold next month to Google or Facebook for a billion dollars - will be to prone to lie.

Or they'll be encouraged to lie, with a wink and a nod. "Just sign here, check those boxes, initial in three places." (The fear, you might say, is that tech startups, giddy with the freedom to actually crowdfund without the strictures of the crowdfunding exemption, might become the new subprime mortgage industry!)

It's a perilous business, this verification requirement. The JOBS Act gives the SEC until a month from today to specify "methods" by which companies must "verify" the accredited investor status of purchasers in the brave new 506 world that will include general solicitation and general advertising. How the SEC writes these rules could conceivably do collateral damage to traditional, non-public, angel investing, which ain't broken. How might the SEC tailor the new rules to the new fears, only?

Annemarie Tierney, General Counsel for the SecondMarket, has written a comment letter to the SEC that takes the straightforward position: preserve the existing Rule 506 for issuers that don't engage in general solicitation or general advertising. Here's the argument from her letter:

"The proposed rules should provide that an issuer who does not generally solicit or generally advertise in the context of a Rule 506 offering is able to operate under the current requirements of Rule 506 of Regulation D and would not be subject to additional requirements to verify the accreditation of potential investors. As is currently the case, a reasonable belief as to the accredited status of an investor would be sufficient in this circumstance."

As for those companies that will avail themselves of general solicitation or general advertising, Tierney has some terrific ideas on how to handle verification.

First, she writes, "the proposed rules should provide an alternative for a minimum dollar investment amount that would create a presumption of accreditation." Tierney doesn't float a proposed dollar figure, but let's say it were $25,000. The rule then might be, if a purchaser invests $25,000 in one lump sum, she or he is presumed accredited.

Second, Tierney suggests, "the verification process could include a requirement that the issuer, or its broker-dealer intermediary, obtain copies of a potential investor's tax returns, W-2, Form 1099 or other income verification documentation for the past two fiscal years, in addition to a pay stub from the current year . . . ."

I've already had accredited investors tell me they are not turning that kind of information over to every single startup company they might be interested in, so the upshot of Tierney's suggestion, in practice, may well be that the whole process is handled by broker-dealers with whom the investors already have a relationship. And in fact, Tierney goes on to recommend "that the SEC should establish specific guidelines that registered broker­ dealers must satisfy with respect to the accredited investor verification process in order to be deemed an approved accreditation verification provider or 'AVP' that can be relied upon by issuers . . . ." (One hopes that startups and emerging companies will be able to reliably and cost-effectively outsource the verification process.)

The most novel part of Tierney's letter, and one I have some misgiving about, is her implicit suggestion that the net worth prong of the accredited investor definition be scrapped.

Her reasoning, I think, follows from her experience at SecondMarket that most accredited investors who certify their status end up satisfying the income test. Tierney feels that net worth will be almost impossible to verify - "potential investors could easily 'game the system' with regard to demonstrating requisite net worth, providing only proof of true assets, while failing to disclose true liabilities" - so she suggests that the minimum investment threshold, the one that would generate a presumption of accredited status, stand in and subsume any effort to verify net worth. In effect, she is saying that investors who claim accredited status, but fail (or don't choose to submit to) verification of accredited-level income, can only prove the requisite net worth by having enough dough to drop in a deal.